Universal banking powers and liquidity creation

Universal banking powers are permissions for a nation’s banks to provide financial services beyond “plain vanilla” banking activities. Some nations restrict banking activities to only services such as loans and deposits, while others permit commercial banks to also engage in investment banking, insurance underwriting, and/or real estate investment activities. Despite the research and policy importance of this issue, the literature essentially neglects how these powers affect the primary role of banks in creating liquidity for society. We formulate two competing hypotheses as to whether more universal banking powers increase versus decrease domestic bank liquidity creation based on theories of risk absorption, relationship banking, and scope economies/diseconomies. We test which hypothesis empirically dominates using data from 85 nations over 15 years. The data strongly support the hypothesis that universal powers boost domestic bank liquidity creation. These findings are robust to addressing endogeneity, controlling for bank regulations, macroeconomic conditions, and institutional variables, and conducting subsample analyses. We also test for international arbitrage – whether the foreign subsidiaries of banks from more restrictive countries create more liquidity in host countries with fewer restrictions – and find support for this arbitrage. Collectively, these results provide important research and policy implications.